By Caroline Baum
Nov. 30 -- There was a time back in the 1980s when bond traders were Masters of the Universe.
The size and stature of the U.S. government bond market had exploded along with the federal budget deficit. The Federal Reserve's inflation-fighting resolve and monetary-targeting regime under Chairman Paul Volcker produced huge swings in interest rates. Volatility acted as a magnet, attracting traders to a market that had formerly been relegated to widows and orphans.
At the same time, the stock market had been going nowhere from the late 1960s to the early 1980s. The go-go years were still ahead.
By 1997 the capitalization of the U.S. stock market exceeded the size of the U.S. economy. Guess which one was driving the bus?
Government bond traders were all but forgotten as derivatives geeks dominated fixed-income desks. The cozy club of primary dealers that deal directly with the Fed had less relevance as hedge funds did pretty much what the dealers could do, only better.
Don't write bond traders off just yet. Diminished, maybe, but not forgotten. What comes as a surprise to the stock market is often old news to the bond market.
Take the events of earlier this week, for example. The Dow Jones Industrial Average soared 331 points Wednesday, the biggest percentage gain in four years. Every stock market story ascribed the broad-based rally to ``hints'' the Fed would lower its target rate again on Dec. 11.
Hints
The hints came from Fed Vice Chairman Don Kohn, whose long tenure at the Fed gives him institutional credibility. Kohn told an audience at the Council on Foreign Relations in New York that policy making needs to be ``flexible and pragmatic.'' He suggested the Fed may have to act to offset the credit restraint resulting from distress in financial markets and problems at financial institutions.
A day earlier, two of Kohn's colleagues sounded as if they had just landed from non-planet Pluto to deliver the gospel on inflation risks.
During all this to and fro from Fed officials, the stock market either had its eyes wide shut or didn't believe what it saw. The implied probability of a rate cut on Dec. 11, based on fed funds futures' prices, has been in the range of 90 percent to 100 percent all week. That's about as good as the odds get in financial markets short of the deed being done.
The entire Treasury market has been challenging the Fed's hawkish rhetoric, goading policy makers with the attitude: My forecast is better than your forecast!
Now or Later
Counterintuitive as it may seem, the more hawkish the Fed rhetoric, the greater the expectation of rate cuts.
``It's like the old Fram Oil commercial,'' says Bob Barbera, chief economist at ITG Inc., a New York brokerage. ``The bond market is saying, `Pay me now or pay me later.'''
Barbera's exhibit No. 1 is the two-year Treasury note. The note's yield fell about 100 basis points from June to August as subprime ``containment'' theory started to fray around the edges. Two-year yields stabilized as the Fed cut the discount rate on Aug. 17 and funds rate on Sept. 18.
When the Fed cut the funds rate again on Oct. 31 and said the risks to the economy were balanced between slower growth and higher inflation, the two-year yield took a dive, falling another 100 basis points in the next three weeks.
Synchronicity
``The market is saying if you don't ease now, you'll have to ease more later,'' Barbera says.
Exhibit No. 2 is the concurrent movement in various instruments' prices and spreads.
``Junk bond spreads, ABX spreads, financial stocks, the dollar, two-year notes: It's all the same trade,'' he says. ``If the Fed doesn't come to the rescue, it's Armageddon. If the Fed comes to the rescue, Armageddon is less likely.''
For the stock market, Kohn's words were a welcome sign that help is on the way. (Translation: No reason to be quite so short.) Why stock investors need extra coddling when the folks in the bond market had already figured it out is anybody's guess. Maybe bond traders shouldn't give away those Master of the Universe T-shirts just yet.
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